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The Case for Small and Mid Cap Stocks in 2013

As the dust settles from the presidential election, investors are regrouping to find how to invest for the next four years. A number of trends look good for the small and midcap corners of the investment universe.

Here's what should drive small and midcap stocks in 2013 and beyond:

Record bond issuance – As we've highlighted in posts about rising junk bond ETFs, there is record appetite for high-yield debt. The corporate bond space is especially hot as companies are on track to issue more new debt in 2012 than in any year before, smashing through a record set in 2009.

Low interest rates – Corporate borrowing is driven by interest rate policy, with debt so cheap from the top to the bottom of the credit quality scale, companies are borrowing for leverage, buyouts, and safety cushions from economic calamity. The leveraged buyout is back as companies enact buyback policies fueled with low interest debt obligations. BBB-rated investment grade debt yields only 3.3% against a long-term average of 6.26%, according to Ycharts.

Corporate raiders have fat wallets – Research shows that private equity firms are well funded, having as much as $355 billion on hand to invest in new deals, according to Cambridge Associates. All that buying power is further levered with bank loans and subordinated debt. While Micheal Milken won't be making a comeback – regulators have capped leverage in a private equity deal at 6 to 1 – the $355 billion in sidelined cash could turn into nearly $2 trillion of new market activity. Private equity will forego management fees if it fails to invest its cash on hand, something I find unlikely to happen.

S&P 500 Cash – JP Morgan reports that this year S&P 500 companies will reach a new record for cash on hand as non-financial firms hold more than $1.5 trillion. That cash could be deployed in new buyouts, or made a target for private equity firms when they exit from portfolio companies 4-6 years down the line. The largest firms could go on an incredible buying spree when investors tire of cash-bloated firms.

The Best Small and Mid Cap ETFs

Here are some of the best small and midcap ETFs for exposure to the stocks most likely to be takeover targets:

SPDR S&P 600 Small Cap Value ETF (SLVY) – This value-oriented fund holds 452 different securities, giving investors broad exposure to the small cap value style. The fund is 58.87% invested in small cap stocks, with 37.69% invested in microcap stocks. MorningStar data reveals it heavily weights industrials (a favored buyout sector) and goes lighter on financials, which are unlikely to be targets for acquisition. With an average valuation of 6.72 price-to-cash flow, and an average market cap of just under $1 billion, this fund parks you right in the middle of bite-size buyout territory. The .25% annual expense is more than affordable for small cap exposure.

iShares S&P Midcap 400 Index (IJJ) – This fund offers it all: attractive average P/E (<14), dividend yield (1.76% for the fund), and a low price-to-cash flow score (6.6) consistent will value stocks perfect for takeovers. The fund's average market cap size of $2.9 billion puts you in the range of stocks that would be picked up in any private equity-led buying spree. The fund holds 298 stocks and carries an annual expense ratio of only .25% per year.

Analysts and strategists are pointing towards accelerated buyout activity. In the past week, Bank of America strategists wrote about their expectations of leveraged buyouts in sizes of $20 billion or more in total enterprise value. Their case was simple: low rates, ample liquidity, relatively strong earnings, and a need for new deal flow for bankers would lead to aggressive shopping by acquirers.

Right Place, Right Time

All signs point to a better market for deals, big and small. Investors who think smaller will be best situated for a rising tide of acquisitions and leveraged buyouts. Being in the right place at the right time is half the battle. In periods of aggressive takeovers, a rising tide raises all ships – multiple expansion plays out as investors anticipate increased take private activity.

The bottomline: allocating more of your portfolio to small and mid cap stocks makes more sense than ever before. Bet on the greed of private equity managers who have to deploy cash to generate management fees. The year 2013 could be the year of the leveraged buyout.

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